Insights

Penalty Provisions more likely to be Enforceable

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Published: 06 March 2017

Parties to a contract often include provisions setting out what will happen in the event of a breach by one of them. They may for example include a provision stating that the party in breach must pay the 'innocent' party a sum of money by way of 'compensation'. It is however, a well-established principle of contract law that where the contractual provision provides for a sum which has the intention of penalising the wrongful party rather compensating the loss that could actually be suffered by the innocent party, the clause could be deemed an unenforceable penalty clause.

Until recently, parties were at risk of their contractual provisions being struck down by a court as being a penalty, where they attempt to go further than pre-estimating the loss that could be suffered upon a breach of the contract. However, the 2015 conjoined cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye v Beavis suggest that this may no longer be the case. The UK Supreme Court held in these cases that a provision which is triggered by a breach, and has the purpose of deterring a breach and punishing the wrongful party is not necessarily unenforceable, even where it does not estimate the loss that could be suffered by the innocent party. Instead the Supreme Court set out a new test whereby a provision in a contract that is triggered by a breach would not be an unenforceable penalty where the intention of the clause is to protect a legitimate interest of the innocent party, provided that it does not impose a detriment upon the party in breach “out of all proportion” to that legitimate interest. This 'legitimate interest' would for example include the interest of the innocent party to ensure performance of the obligations under the contract (but could include other legitimate interests).

The outcome of these cases means that provisions which might previously have been struck down as unenforceable penalties are more likely to be upheld where it can be demonstrated that they have been included for the purpose of protecting the legitimate interests of parties and are not disproportionate to those interests. This could be good news for the oil and gas industry as there has always been debate as to whether forfeiture clauses included in joint operating agreements could be unenforceable penalties. Such provisions commonly provide that a defaulting party is required to forfeit their interest in any production upon failing to meet a cash call. These provisions might now be justified on the basis that the parties have a legitimate interest in cash calls being met so that the project can operate without delay. Such a delay in the oil and gas industry would likely have very high financial repercussions and therefore a forfeiture provision might not be considered to be disproportionate in the circumstances.

If you have any queries in relation to the above please get in touch with a member of the Stronachs Upstream Oil & Gas Team.